By Pranjul Bhandari, Aayushi Chaudhary & Priya Mehrishi
The last few months have been great for the economy. New cases have fallen, and economic activity is racing back to pre-pandemic levels. After a c.24% contraction in the quarter ending June 2020, we expect GDP to grow by a positive 1.8% in the quarter ending December 2020.
This is quite a sharp turnaround in a short period. A careful look suggests that a key driver of the rebound has been pent-up goods demand. As the lockdown ended, the production of consumer non-durables shot up, followed soon by consumer durables. A large mountain of household financial savings funded this rebound.
Alas, we also find that goods demand is back at pre-pandemic levels and may not be the key driver of a continued rebound. Thankfully, pent-up services demand can play that role. Still 25% below normal, services can get a shot in the arm as herd immunity rises, in part led by vaccine roll-out. GDP growth is likely to be strong for the next few quarters, rising from -6.3% y-o-y in FY21 to 11.2% y-o-y in FY22.
But then, what next? By definition, pent-up demand is a one-time driver of growth. Once services demand is back at pre-pandemic levels, say by end 2021, what will drive growth? It is possible that the scars the pandemic leaves behind will begin to show up around that same time, presenting a double whammy for growth.
And this is where the centre stepped in with the budget. It tried to introduce a new narrative for medium-term growth, namely capital expenditure. In particular, it introduced the following:
- The capex budget was raised by 0.8% of GDP over two years (FY21 and FY22). In fact, only after adjusting for the higher capex multipliers is the FY22 fiscal impulse positive.
- The government did not impose any new taxes/cesses, nor did it make changes in capital gains tax. Our previous work has shown that policy stability tends to crowd-in private sector capex.
- The government outlined plans to create two new institutions, a bad bank and a DFI, although much will depend on the design and implementation over time.
On Feb 5, RBI outlined its role in this new narrative–not being the main driver of growth as it was in 2020, but playing a supportive role and helping it through its larger-than-expected market borrowing.
RBI will have to tread the fine line between normalising liquidity (especially with inflation likely to be north of the 4% target over the next year) and maintaining orderly conditions in the bond and FX markets. Liquidity switching could help. For instance, it could use the space freed up by the reversal in CRR cut for bond purchases. Or, in the face of a rising trade deficit and falling BoP surplus, it could focus more on bond purchases than dollar purchases.
RBI is expected to start raising the reverse repo rate in 2H2021, the repo rate may remain unchanged at 4% over the foreseeable future, doing its bit for keeping interest rates as low as possible.
But will the grand partnership really provide the new medium-term growth driver that the country needs and the market believes? Will it fill the space, the pent-up demand vacates?
We recently estimated that potential growth had fallen to 6% on the eve of the pandemic, from 7%+ a decade ago; and may fall by 1ppt more by the time the pandemic is behind us. Will potential growth rise back up over time? These are questions that can’t be ignored. The answers lie in the turnout of four important issues: (1) the government’s grand capex plan; (2) the ambitious PLI scheme; (3) the health of India’s banks; and (4) the tension between formalisation and inequality.
Higher central outlays, a stable tax policy and low-interest rates have been important drivers of investment. And in hailing these, the Budget did make a fair effort to give investment-led-growth a chance.
Is the plan good enough? Public sector makes up 25% of the overall investment., remainder is private. Of the 25%, state-led capex is more than double centre’s capex, and has been hurting on the back of revenue shortfalls. As such, the centre’s capex is at best a necessary condition, not a sufficient one for a meaningful rise in economy-wide investment. Other factors such as prospects for future growth and returns and the health of corporate and public sector balance sheets play a meaningful role.
Past experience suggests that centre’s capex is the first victim of lower than budgeted disinvestment receipts. This year too, the capex budget (0.2% of GDP higher than last year) depends on the successful shoring up of disinvestment receipts (budgeted at 0.6% of GDP higher). And finally, notwithstanding the RBI’s intent of keeping rates low, the large borrowing calendar has been pushing yields up.While the centre’s capex focus is a big positive, any shortfall in budgeted disinvestment revenues could hurt the actual outlays. For state government and private sector capex to take off, other parts of the economy need fixing.
PLI scheme has been a success for electronics production (as well as medical devices and bulk drugs), and has now been extended to cover about 10 new sectors.
This, many believe, could support jobs, capex and exports, even GVC integration. The ‘picking winners’ strategy has helped some other Asian countries. And the structure of the current PLI scheme has been carefully thought through, building on the success with electronics.
Can the PLI scheme alone usher in higher sustainable growth? Financial incentives can help in early stages but can’t be a substitute for R&D culture–necessary to stay on top of the game. Moreover, the real problem is unease of doing business—high regulatory burden, onerous labour laws, problems in acquiring land, etc.
Finally, the government has been raising import tariffs on a wide variety of goods over the last few years. As is well known, higher import tariffs can raise economy-wide cost of production, even working as a tax on exports. And past attempts (in the 1970s) to follow a strategy of import substitution and export promotion together have not worked out.
The PLI scheme can give an important initial push, but sustainable growth requires improvements in EoDB, R&D culture and a move away from import tariffs.
In good news, the capital buffers of banks have improved in recent quarters. After peaking in March 2018, NPAs have also been on a downward trajectory. Risk aversion and the consequent fall in credit growth had been a key driver of the fall in growth in the few years preceding the pandemic. Improvements in the banking sector could potentially bode well for growth.
Yet, the uncertainty around the health of the banking sector can’t be ignored. One, in previous slowdowns too, the rise in NPLs showed up a year or so down the line. Two, the IBC remains suspended, with a long queue of pending cases even before the pandemic hit. Three, the success of the bad-bank-like-institutions floated in the Budget will depend on the structure it takes.
There are many issues–seed funding and the actual resolution process–which need to be thought through carefully.
While capital buffers at banks have improved, there is uncertainty around the evolution of NPLs. Large and listed firms have benefitted through the pandemic, and the resultant “formalisation” has shown up clearly in corporate results. Given the large efficiency gains associated with the formal sector, it is no surprise that equity markets continue to cheer.
But “formalisation” can be a double-edged sword. If it happens at the cost of putting small informal firms out of business, then the disruption can weigh on demand in subsequent periods–85% of economy is informal. If the formalisation wears off over time, as happened during demonetisation, then the efficiency gains wear off as well. The constructive way to think about this is perhaps to differentiate between ‘forced’ and ‘organic’ formalisation. The formalisation that comes only on the back of external pressure and leads to distress in the informal sector may not be sustainable. In contrast, the formalisation that happens on the back of policy changes, which helps small and informal firms grow over time into larger formal sector firms, is perhaps more sustainable.
What is perhaps needed now is to protect the bottom of the pyramid via social welfare schemes so that the disruption they are facing does not lead to a permanent fall in demand. And in the meantime, the government needs to push on with reforms necessary to help small businesses grow (for example, lower the regulatory burden associated with growing firms).
Forced formalisation, which happens on the back of disruption in small firms, may lead to demand-side problems. This can, however, be overcome by supporting bottom-of-the-pyramid firms and workers during difficult times.
The much-needed X-factor: The government’s intention to introduce a medium-term growth narrative is welcome. But whether what’s on paper also happens in practice will depend on how carefully each of the announced measures have been thought through and how well they are executed. As argued before, thinking through a reform carefully from start to finish and continuing to improve it
Here are the developments we will be watching out for to ascertain whether India’s growth uptick is sustainable or not:
Getting disinvestment done: Given buoyant markets, now is the time to speed up disinvestment.
Moving from import substitution to export promotion: The budget outlined plans to have a revised customs duty structure; the details of this plan should make clear the direction the country is taking.
Reinstating the IBC: The sooner itsdone, the better the chance to overcome banking sector strains that could pile up.
Continuing with social welfare spending: One metric to monitor the government’s support to the bottom-of-the-pyramid is the demand/supply gap in the NREGA programme (demand has been outpacing supply recently).
India could shed the pandemic scars and aim for the starts if it gets some things going.
Edited excerpts from HSBC Global Research report titled Stars or scars?, dated February 19. 2021
Bhandari is Chief Economist, India, Chaudhary is Economist, and Mehrishi is associate, HSBC Securities and Capital Markets (India) Private Limited. Views are personal